Fitting annuities into retirement plan

Though controversial, these products have a place in retirement

Retirement planning involves a lot of options and a lot of uncertainty. One of the most important questions facing those heading into of retirement is also one of the hardest: How long will my retirement income need to last?

As life expectancy continues to climb and traditional pension plans give way to 401(k)s and IRAs, longevity has become a pressing issue for those planning their retirements. And annuities, carefully chosen, can offer a possible solution.

Annuities are controversial because some come with high fees, and they may not pay off as much as other investments. But some retirement specialists said annuities have their place because they offer peace of mind: They act as insurance policies that protect retirees from outliving their income. One way to treat annuities is as a piece of an overall package of retirement tools that allow investors to take a portion of their savings and convert it into guaranteed income for the rest of their lives. Many factors go into choosing an annuity. Among the most important are determining your income needs during retirement and deciding when you want the money: now or down the road?

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•Immediate annuity: These are purchased with one upfront lump sum and, as the name suggests, begin paying income at once. They can make sense when treated as an insurance policy rather than as an investment because they will continue to pay you until you die; that is, the immediate annuity offers protection against the possibility of living — and spending — longer than expected.

But immediate annuities have their risks, said William Driscoll of Driscoll Financial in Plymouth: If you die shortly after buying one, “the insurance company has just made a lot of money.”

•Deferred annuity: These begin paying out at a later date, usually when the investor reaches a certain age. Deferred annuities are broken into two time periods: the savings section where ideally your payments appreciate over time, either at a fixed rate or by the performance of the investments in the annuity; and, the withdrawal phase during which the annuity makes payments back to you.

Also, deferred annuities often have terms that allow buyers to get their money back after a certain length of time, known as the “surrender period.” Driscoll said this may make them a good choice for some investors who want a lifetime income stream without the same level of commitment as immediate annuities.

Deferred annuities, which make up the majority of sales in the industry, have their skeptics. High fees and complicated terms can make deferred annuities “expensive and inflexible,” said Anthony Webb, research economist with Boston College’s Center for Retirement Research. “If your primary goal is to maximize retirement income, then these products don’t do as good job as the regular immediate annuity,” he said.

From here investors with a higher appetite for risk can ratchet up their potential payback from an annuity. Immediate annuities generally earn interest at a fixed rate, while deferred annuities offer more choices, including fixed rates, variable rates, and hybrid options.

In variable annuities, the principal is allocated into different investments that are designed to deliver a better rate of return than a more conservative fixed-rate annuity. But as with any such investment, investors expose themselves to possible losses, said John Spoto, founder of Sentry Financial Planning in Danvers.

“Of course, if you participate in the upside, that means you are also going to be exposed to the risk on the downside,” he said.

Variable annuities are also frequently subject to significant fees and complex terms, and in many cases the potential benefits do not outweigh the costs, financial planners said.

Other types of annuities can be used to protect against inflation. Though inflation is low now, many people in or near retirement can remember when price appreciation was a real menace in the 1980s. An income that pays the rent and buys the groceries today may not cover those same bills 20 years down the line.

To guard against this risk, many companies offer annuities with payment rates set to increase along with inflation. Such products however, will generally provide lower initial income than a similarly-priced product that does not adjust for rising prices, Webb said.

While money in an annuity generally cannot be left to your heirs, there are some annuities that will continue to pay your survivors for a specified length of time — known as a “period certain” benefit — if you die before the end of the defined time. An heir or beneficiary would then continue receiving the regular annuity payments until that period expires.

The current investment climate makes buying an annuity difficult, because interest rates are so low companies are not offering big payout rates. Most immediate annuities pay a fixed rate of return, and while some states set a minimum allowable rate — 3 percent in Massachusetts — the income a fixed-rate annuity can provide is still highly dependent on economic conditions at the time of purchase.

“The payment of your annuity is going to be influenced by the current rate environment,” Spoto said. “So when interest rates are low, like they are now, that does not spell good news.”

To get around this, some financial advisors recommend a practice known as “laddering” in which investors buy a series of smaller annuities at intervals. This gives regular income at the outset, and allows investors to wait until interest rates improve and get a better deal with a later annuity.

Investors need to be careful shoppers for annuities, considering only those from highly rated companies, and paying attention to small differences among offerings that can add up to significant money over the decades, said Webb.